Corzine Forgot Lessons of Long-Term Capital: Roger Lowenstein

Nov. 2 (Bloomberg) -- Thirteen years ago, when the hedge
fund Long-Term Capital Management was desperately negotiating
with Wall Street banks for a bailout, Jon Corzine, the chief
executive officer of Goldman Sachs Group Inc., called John
Meriwether, LTCM’s founder, and read him the riot act. Wall
Street would invest, Corzine said, but “JM” would have to accept
more controls, including strict supervision over his firm’s
trading limits.

Corzine, I wrote soon after, “understood the flaws” at LTCM
better than anyone. The firm had no controls over risk limits,
no accountability to anyone who wasn’t a trader.

Corzine was also tempted by the upside of high-risk trading
-- and by Meriwether in particular. Perhaps his admiration for
Meriwether didn’t begin when they were classmates at the
University of Chicago Booth School of Business, in the early
1970s, but it blossomed soon after, when Corzine became a bond
trader at Goldman and Meriwether one at Salomon Brothers.

Goldman, in that era, was still a firm guided by investment
bankers, sometimes in tandem with traders but always with the
motto “long-term greedy” rather than short-term. Its primary
mission was doing deals for clients. Since Goldman was private,
its partners avoided taking too much risk with the firm’s
capital -- which, of course, was their own capital.

Salomon was brassier -- perhaps because it didn’t have a
gold-plated roster of clients to fall back on. At Salomon,
Meriwether built a trading powerhouse, one that Corzine envied.
In the early 1980s, Salomon became a public company, and
Meriwether’s famous bond arbitragers had more capital to trade
with.

Rise of Trading

The shorthand story of Wall Street over the last generation
is that every firm -- Goldman included -- became less like the
old Goldman, more like Salomon. Old-line commercial banks like
JP Morgan and Bankers Trust were converted into derivatives
traders. Venerable investment banks like Lehman Brothers and
Morgan Stanley became packagers of mortgages -- essentially,
shops for buying and selling, assembling and splicing, mortgage
securities. And all with other people’s money.

By the mid ‘90s, Corzine was the top executive at Goldman
and it, alone among the major Wall Street firms, remained
privately owned (it went public in 1999.) But even Goldman was
metamorphosing into a trading powerhouse. Corzine knew the risks
(Goldman was burned in the volatile market of ‘94) but he was
also sensitive to the potential profits. That same year, when
Meriwether founded LTCM, Corzine flirted with the idea of buying
an investment in the hedge fund.

He didn’t, but Goldman did become a banker to LTCM, and on
attractive terms to the fund. Corzine wanted to be close to LTCM
-- surely because, if Meriwether’s team was on to a good trade,
Corzine wanted Goldman to be there, too.

In September 1998, after Russia defaulted on its debt, LTCM
blew up. Some people thought the firm’s arbitrage trades were
well-conceived, some thought the firm was arrogant, but everyone
understood their mistake. LTCM was too leveraged. If 97 percent
of your capital is borrowed, you can’t afford to make a trade
that may be correct eventually, because in the meantime
creditors will put you out of business.

Strongly cajoled by the Federal Reserve, Corzine and other
Wall Street CEOs engineered a rescue of LTCM. Shortly after,
Corzine’s Goldman partners forced him out. But Corzine’s romance
with Meriwether wasn’t over. The two lions of Wall Street, both
in a sort of exile, fantasized that they, together, could buy
the hedge fund from the Wall Street banks that had rescued it.
They tried to raise money, but the effort fizzled.

The lesson of LTCM was that no trading operation is better
than its ability to withstand losses. This lesson was proved in
spades, in 2008, at highly leveraged banks such as Bear Stearns
and Lehman Brothers.

A History Lesson

A second lesson is that seemingly unlikely events may be
more likely than market history suggests. Russia had not
defaulted since 1917, but that didn’t stop it from happening in
1998.

And a further lesson of LTCM’s demise was that the
widespread belief that liquidity offers safety is, in fact, an
illusion, and a terribly dangerous one at that.

Time and again, otherwise canny investors fall for the
salve that in a liquid market, they can always get out,
therefore what’s the problem? At Lehman, in the mid 2000s,
executives took comfort in the notion that that the bank was in
the “moving business” not the “storage business.” Then, the
mortgage market froze, and everyone was in the storage business.

Liquidity is a backward-looking yardstick. If anything,
it’s an indicator of potential risk, because in “liquid” markets
traders forego trying to determine an asset’s underlying worth -
- they trust, instead, on their supposed ability to exit.
Investors now in low-yielding U.S. Treasury bonds may, one day,
discover this lesson for themselves.

It’s hard to overestimate the extent to which the siren of
liquidity has seduced even ordinary Americans. During the
housing bubble, anyone who took out a mortgage they couldn’t
afford, upon advice they could always refinance, was tacitly
assuming they could trade their old loan for a new one. They
were counting on continued liquidity in the mortgage market--and
so were the banks that lent them the money.

Corzine was able to sidestep the subprime madness by
becoming a U.S. senator from New Jersey and then governor. As a
public servant, he seemed more cautious than in his CEO days. In
Trenton, he never quite commanded the stage, nor did he solve
the tremendous fiscal woes he inherited as governor. In his re-election bid in 2009, he was defeated by Chris Christie.

I liked him as an executive and as a public official (on
one occasion, we shared a classroom at Princeton University).
Like few very wealthy banking executives, Corzine saw Wall
Street’s shortcomings, had a sense of its role in society. And I
wondered, after he was retired from politics, why he chose to
return to the Street, taking control of a futures broker, MF
Global Holdings Ltd., which collapsed spectacularly this week.
It now looks as though Corzine still felt the trader’s itch.

Betting the Firm

MF Global was leveraged 30 to 1, shades of LTCM. And of MF
Global’s roughly $40 billion in assets, more than $6 billion
were in volatile European sovereign debts. Corzine was the
author of the firm’s strategy of risking its own capital. He
wanted a firm like Meriwether’s, and he got one. Corzine also
approved the strategy of loading up on European debt. According
to the Wall Street Journal, he told a company executive that
“Europe wouldn’t let these countries go down.” Just as, 13 years
ago, traders believed that Russia wouldn’t default.

Corzine’s bet may still prove correct; “these countries” --
Italy and Spain, for instance -- may emerge from the current
crisis solvent. But if they do, MF Global will not be around to
reap the gains. Because the firm was so highly leveraged, and
because it was dependent on short-term financing, its liquidity
dried up and it failed. This seems to be the lesson that Wall
Street never learns.

The good news is that MF Global was just a brokerage, not a
first-tier investment bank. The world will get by without it.
Fortunately, thanks to the post-crash Dodd-Frank legislation --
the Volcker Rule in particular -- regulated banks are prohibited
from risking their capital in proprietary trading. They will
also have to maintain higher capital levels.

There is room for further reform as well. The culture of
trading has overwhelmed Wall Street’s economic function, which
is simply to provide a conduit for savings into productive use.
Instead, too much of Wall Street has become a casino. A tax on
financial transactions to slow down trading would be a good
place to start. And the collapse of MF Global reminds us why,
for all its unfortunate complexity and verbiage, Dodd-Frank
was necessary.

Someday, business schools may teach their students about
liquidity and risk, about the perils of short-term funding and
leverage. Someday the lessons of LTCM may be learned. But don’t
hold your breath. Corzine had a ringside seat, and the message
didn’t stick. Human nature loves a risk. Best to keep the
gamblers where they can’t do so much harm.

(Roger Lowenstein is the author of “When Genius Failed: The
Rise and Fall of Long-Term Capital Management.” He is an outside
director with the Sequoia Fund. The opinions expressed are his
own.)